Pundits continue to expound on the flaws of the eurozone but
markets are telling a different tale.

That's because the European Central Bank may have already
introduced roundabout measures that will solve some of Europe's
big problems—it's making investing in peripheral
sovereign debt a huge profit opportunity for banks.

Theoretically, financial institutions will be able coin
money by borrowing ultra-cheap from the ECB and buying higher
yielding sovereign debt.

Essentially, it appears the ECB might allow European banks to
pledge everything but the kitchen sink in return for funds.
First, the new policy allows European banks to hold far fewer
assets as collateral in exchange for funding from the ECB—freeing
up liquidity to the tune of €103 billion ($134 billion). More
importantly, relaxing collateral restrictions could also allow
European banks to use even somewhat risky sovereign assets as
collateral for bond purchases.

Finally, the extension of loan maturities to a full three years
means that banks would be able to borrow money for the long-term,
presumably long enough for EU leaders to make more progress
towards solving the flaws of the euro monetary union.

While analysts on the whole had expected the ECB to announce
changes to long-term lending to banks (LTROs) in their
monetary policy decision last week, the buzz is that the
measures may have been far beefier than people realized -- this
was argued to us by Lorcan Roche Kelly, Chief Europe Strategist
at Trend Macrolytics.

The details of how the ECB means to relax collateral have not yet
been released. The Bank currently accepts collateral rated as low
as A-, although debtors must pay a penalty based on asset risk.
Were even riskier assets allowed to be used as collateral or if
the penalty were dropped, this would provide significant
incentive for banks to purchase sovereign debt, particularly
given currently high yields on bonds. If it worked, it would be
the ultimate carry trade—borrowing from the ECB is now a cheap
1%, so banks could see huge returns on sovereign debts with high
yields.

That would hike demand for sovereign debt in countries that have
currently seen high borrowing costs, bringing down yields on
sovereign bonds, and thus making it easier for PIIGS sovereigns
to finance their debt.

Changing collateral policy is not without significant risk to
banks, and consequently ECB's balance sheet. From Citi's Steve
Englander:

One issue for the banks is that if they were to do
the ECB’s job and stop the sell off in the European sovereign
debt markets, they would be exposed to PSI-type restructuring,
despite the insistence of euro zone governments that PSI will
never extend beyond Greece. We suspect that it will be
very difficult for the euro zone core countries to pre-commit to
absorb credit risks related to Italy and/or Spain. While more
bailouts could help market sentiment, the fact that the official
lenders (the likes of the IMF and the ECB) are still perceived as
more senior to private bond holders could reduce the positive
impact of the measures even if PSI is not part of the deal ex
ante.

Essentially, this new policy is really a test of confidence. If
banks believe that countries like Italy and Spain can continue to
pass austerity measures and that EU leaders will continue to move
towards fiscal consolidation that will make the euro area more
stable in the future, then they will buy PIIGS sovereign debt buy
the bushel, as there is no limit to the ECB's funding policy. If
not, then they won't buy enough and the crisis will continue to
intensify.

These new collateral guidelines will probably go into effect as
early as next week, at the first 3-year funding offering. the
results of the next 3-year LTRO offering will be published on
Wednesday. So by this time next week, the euro crisis could be
over—or it could be far worse than the ECB imagined.